The proposals on capital gains in the Direct Taxes Code will have an adverse impact on the taxability of FIIs.

C. A. Gupta
Sarika Dhameja
Deepa Bakhru

There appears to be a paradigm shift in the taxability of gain on sale of assets in the draft Direct Taxes Code Bill, 2009. The Code classifies the assets of the taxpayer into business and investment. If the asset qualifies as business asset, the income from transaction of such asset would be taxable as business income and those qualifying as investment assets would be taxable under the head capital gains.

Business asset is defined under the Code to mean business trading asset and business capital asset. A business trading asset has been defined to mean stock-in-trade, consumable stores or raw materials held for business.

A business capital asset is any capital asset self-generated in the course of business; any intangible capital asset of the nature specified therein; any tangible capital asset in the nature of building, machinery, plant or furniture; or any other capital asset connected with or used for any business of the assessee.

An investment asset has been defined to mean any capital asset which is not a business capital asset. The Code also specifies certain instances of transfers, income from which is not to be treated as capital gains for example, transfer under certain business reorganisations, conversion of bonds into debentures, etc.

Under the Income-Tax Act, 1961, there is generally no distinction between an asset held for business or otherwise. Accordingly, the gain arising on the transfer of any capital asset whether connected with business or not is taxable as capital gains in most of the cases under the current law.

Sale of shares

The Central Board of Direct Taxes (CBDT) issued Circular No. 4/2007 dated June 15, 2007, laying down the principle for taxability of shares as business income or capital gains. The aforesaid circular indicated that where the shares are held as stock-in-trade or where the sale is for a business motive, the gain would be taxable as business income. In spite of this circular, a debate still continues on the treatment of such gains on sale of shares, that is, whether the same should be taxed as business income or capital gains.

Under the Code, the gain arising on the transfer of any capital asset connected with or used for business would be taxable as business income. Similarly, the gain arising on the transfer of a business trading asset would qualify as being in the nature of business income.

In other words, the income arising on sale of shares which would ordinarily be treated as being in the nature of capital gains, could still be held by a tax officer as being in the nature of business income on the ground that the shares qualify as a business capital asset being held in connection with or used for business or that the intention of the taxpayer is to trade in shares and, therefore, the shares qualify as being in the nature of stock-in-trade and hence a business trading asset.

A question will still remain as to whether the Code settles the debate/controversy by classifying the assets as business and investment.

However, it may be noted that as capital gains are taxed at progressive rates in the case of individuals and HUFs and applicable rates for others, there is no likely tax benefit to be derived by a tax officer in classifying the gain as business income except that the indexation benefit may be disallowed by him in such cases.

In fact, it may be more beneficial for the taxpayers to treat the shares as business asset and offer the same to tax as business income as the rate of tax would be the same irrespective of the classification, whereas in the case of business income, the taxpayer will be eligible to claim the related expenses and set off of business loss. However, the applicability of other related compliances such as tax audit may then be applicable and need to be evaluated by the taxpayer.

Rate of tax

Under the existing provisions, capital gains on transfer of listed securities and other securities on which Securities Transaction Tax (STT) is paid are taxable at concessional rates depending on the period of holding of the asset, that is, long term or short term. No tax is currently payable on such long term capital gains, whereas such short term capital gains are taxed at 15 per cent.

The new framework proposes to eliminate the present distinction between short-term (capital) investment asset and long-term (capital) investment asset. Accordingly, the capital gain on sale of such assets, short term or long term, would be taxable at the normal rates. In the case of non-residents, capital gains would be taxable at a flat 30 per cent.

The Code does not provide for any concessional treatment for capital gains earned by a foreign institutional investor (FII) which will be taxed as any other non-resident. In other words, the proposed provisions will have an adverse impact on the taxability of an FII in India as they would now be liable to tax at 30 per cent vis--vis the concessional rates ranging from 0 to 30 per cent as may be applicable under the current provisions.

Indexation Benefit

As a matter of relief, the Code does provide for considering the indexed cost of acquisition and the indexed cost of improvement if the assets are transferred at any time after one year from the end of the financial year in which such asset was acquired.

In addition, the base of cost of acquisition is changed from April 1, 1981 to April 1, 2000. This is a welcome change as this will provide a protection against inflation and increased cost base as compared to the existing base of April 1, 1981, if there has been a continuous appreciation in the value of the asset. In other words, no capital gains tax would be payable on the appreciation in value of the assets between April 1, 1981 to March 31, 2000.

Indeterminable cost

Under the proposed regime, the cost of acquisition or the cost of improvement of an investment asset shall be deemed to be nil if it cannot be determined or ascertained for any reason, and capital gains will be computed accordingly.

The Code intends to overrule the decision of Supreme Court in the CIT vs B. C. Srinivasa Shetty case and other similar decisions.

Wherein it has been held that gain from the transfer of assets will not be subject to income-tax if the cost of acquisition of a capital asset was indeterminable.

It was held that the machinery provisions for computing capital gains fail and, therefore, no portion of the gain could be subject to tax.

Rollover benefit

Under the existing Act, gain arising on the transfer of a long-term capital asset is not liable to tax if the net consideration/capital gain is invested in a specified asset within a specified time and in a specified manner.

While such benefit, referred to as rollover benefit, is available under the Code, the number of such avenues/opportunities is however limited. Further, such benefit of rollover is available only where the original investment asset was acquired prior to one year before the beginning of the financial year in which the asset is transferred subject to certain conditions.

Capital losses

It is also interesting to note that the loss under the head capital gains, if any, is proposed to be allowed to be carried forward indefinitely. Under the existing provisions, there is a limit of eight years on carry forward of such losses.

However, there is no clarity on the carry forward and set off of unabsorbed capital losses that pertains to the years till the new Code becomes effective, that is, April 1, 2011.

Under the existing provisions, STT is applicable on purchase/sale of securities through stock exchange. However, the Code proposes to abolish the STT on the same.

In sum, though the new Direct Taxes Code Bill, 2009 on the taxability of the capital gains is simple and rationalises the taxability in terms of consistency in tax rates, it may have a long-lasting impact on the investment patterns of the investors as no incentive (apart from indexation) is available for holding the investments for a longer duration.

Further, there would be no benefit for investments in listed shares and stocks which is very important for the growth of the capital market. The investors may tend to invest in and earn short-term gains which may not be a healthy practice in the long run. In view of the same, the Finance Ministry may accordingly consider providing some incentives for the long-term holder of shares of listed companies.